Friday, February 09, 2018

A simple Dow Jones targeting monetary policy

For some two years, the world's stock markets have enjoyed a calm era with a seemingly healthy growth. The volatility was almost zero and the positive returns looked as safe as if you buy the Bitcoin. Needless to say, aside from the fact that the companies have some intrinsic value which is why investors know that the prices shouldn't drop too low, the emotional part of the price swings is completely analogous in the case of the stocks and the Bitcoin. A difference is that emotions decide about some 30% of the stock prices but about 100% of the cryptocurrency prices.

OK, this calm era ended abruptly when the stock market indices saw a terrible week, with at least two days of 4-5 percent drops per day. The main reason that is cited is the U.S. investors' realization that the interest rates will go up.

Now, unfortunately, I couldn't predict the precise timing but I did predict all these events qualitatively. For some 5-10 years, we saw the era of extremely low interest rates combined with low inflation. Well, the interest rates were really zero in many countries while some countries started experiments with negative interest rates.

Negative interest rates look like a borderline contradiction. Why would someone lend his money for a negative return? Isn't it better to keep the money at zero interest rate, e.g. in the basement? Needless to say, whether this is a real contradiction depends on "who is the someone". Some institutions don't really look for profit or may be regulated so that "they're not allowed to do certain things" which is why negative interest rates may be enforced there.

But yes, I think it would be paradoxical and market-wrecking if true negative interest rates made it to the real economy involving regular people.

Nevertheless, why did we go through this long era of vanishing interest rates and what was the future? Some people were predicting that those would be here forever. I knew it was complete nonsense. The vanishing interest rates were inevitably a temporary anomaly and an eventual growth of the inflation rate and the interest rates – possibly a speed growth – was an unavoidable outcome at some moment. Czechia was among the first ones that saw this return of the inflation and the interest rate hikes that reacted to the resuscitated inflation pressures. Our inflation exceeded 2% for more than a year.

Why was it inevitable? Because when the interest rates are too low, the money is simply piling. It's just too easy for the people to borrow the money even if they don't really need it. Some of it is used to buy products, some of it is invested. These processes unavoidably exert a positive pressure on prices of products, prices of assets, and indirectly on wages, and the return of the inflation simply cannot be prevented.

So the stock markets have grown more quickly than rationally roughly since the election of Donald Trump (who has a higher approval rate than Obama had 8 years ago exactly in the same stage of the presidency, by the way: so much for all the hysteria about the most catastrophic U.S. president). Some of the growth of the U.S. stocks seems absolutely sensible – especially because of the approved lower corporate taxes, some 20% uptick of the stock prices is justifiable. But the growth was even faster than that.

And now this excessive growth entered a correction. Well, everyone who has enough stocks hopes that this will be called a correction in the future.

Over the years, I've spent a nonzero amount of time by trying to develop more efficient, stable, productive, safe rules for a monetary policy and/or methods to collect taxes and tax revenue and other things. I think that I can design rules that need vastly less paperwork and that are much more resilient to shocks.

These days, central banks typically regulate the interest rates to achieve their approximately 2% inflation rate. The U.S. Federal Reserve is actually considering a clear transition to this regime, too. That's what we were told yesterday. I think it would be progress. Instead of the targeting of the inflation rate, a better system is the targeting of the actual integrated inflation rate – the price of the actual inflation basket. This would do a better job in counting episodes in which the inflation is overshot or undershot.

You may define the inflation basket in various ways – I think that the expenses that the poorest people have to pay should still be the most important component of such a basket if one exists at all (because those people are most sensitive to changes of the price level of the products they need). However, you may replace the inflation basket by the GDP or GNP. Instead of targeting inflation, you may target the nominal GNP which may be required to grow at a 5% annual rate. Sweden has tried it, I think.

On top of that, I think that corporate taxes should be replaced by the government's ownership of some 20% of the companies – so that it would simply get a part of the dividends like everyone else. Those could be non-voting stocks (you don't want communism in which the government officials influence the commercial sector much) although I suppose that left-wing government would try to change it. But the unification of corporate taxes and dividends – the government is just another stockholder and companies don't pay extra taxes – would simplify things and it would also create a better "mood" concerning the role of the government. The government isn't some ultimate dictator above everybody; it is a minority shareholder and it may want to behave accordingly.

There are mood swings in the market and they lead to oscillations in the inflation rate and other things. And the central banks are effectively trying to counteract these swings and regulate the inflation rate. You might say that by their changes to the interest rates (and sometimes by exceptional policies such as the quantitative easing), the central banks are indirectly trying to regulate the mood itself – the exuberance vs fear – to achieve stable conditions. It's the emotions, exuberance and fear, that seem to matter fundamentally. And they use things like the inflation rate to measure the mood.

Well, if you accept this picture that the central banks regulate the psychology – excessive exuberance or excessive fear – then your next question should be: Aren't there better ways to measure it than to look at the inflation rate? The inflation rate is confusing and delayed etc. Of course there are better ways. And I think that the stock market indices are actually some of the best simple indicators.

The stock market drops are not only a great indicator of a negative mood swing that will lead to deflationary pressures; stock market drops are also the most important causes of recessions and depressions. That was the case in 1929 and 2008, too. And it makes sense to fight against the primary causes, not just symptoms, of recessions, which is why it's a good idea to discourage big stock market drops.

When the Dow Jones drops some 10%, as in a recent week, it isn't just some arbitrary isolated figure. It's also a very strong sign that the mood has deteriorated and people and companies will be less willing to spend and invest. So already this drop of the stock market could be a good reason to revise the plans for the interest rate hikes in the downward direction. Well, because the drop of the stock market is driven by the realization that the interest rates will go up, the rule that the "interest rates won't go up too fast because the stock market has dropped" would decelerate or stop the stock market drop which could be a good thing.

Some of my proposed recipes for an optimal monetary policy involved some rather complicated formulae etc. Instead, one could demand that the monetary policy rules should be extremely simple so that everyone may quickly understand it and sort of figure out what the consequences are. In the past, I was proposing "Dow Jones money", a money unit linked to the Dow Jones index, which would have many advantages. (The Dow Jones index would become a strictly predictable, smoothly increasing function of time, when expressed in these money units.) But the transition to that new regime could be controversial (but doable).

What about the following simple rule that has "similar" outcomes?

Just define the target for the Dow Jones index. It is meant to be 22,000 on January 1st, 2017 – near the beginning of the Trump presidency – and increase 6% a year. So it's expected to be 23,320 on January 1st, 2018, respectively (sorry, in this way, one would expect further drops now LOL, maybe we should increase the base so that no drop is expected now). And you may calculate the expected value of the targeted Dow Jones index for every day by interpolation – by the smooth exponential function.

Now, the role of the Federal Reserve during the monetary meeting would be simple. If the Dow Jones on that day is equal to the targeted one within e.g. 10%, then the Feds do nothing. When the Dow Jones is lower than the target by more than 10%, they lower the interest rates by 0.25%, When it's higher than the target by more than 10%, they increase the interest rates by 0.25%. There could be special rules that ignite changes of the interest rates that are higher than 0.25% in either direction, too.

In this way, everyone would know that if the stocks go too low, the Fed will help. If they get too high, the Fed will discourage the companies by higher interest rates. One would automatically get some reasons to believe in the relative stability – and the stability would be imprinted to the real world as a self-fulfilling prophesy. Investors would be less likely to join massive mood swings together. On top of that, the price level would also be relatively stabilized because the long-term, averaged over years ratio of the Dow Jones and the price level is relatively constant.

I do believe that the excessive short-term and medium-term mood swings – the the heavy swings of the overall stock indices (and sometimes even restricted stock market indices that only measure one sector of the economy) etc. – play no useful role in the markets. They're a net negative, basically negative consequences of an imperfect choice of the money and/or monetary policy, and these oscillations should be suppressed to achieve a more optimal system.

Three paragraphs above, I wrote about the "plus minus 10% tolerance" for the Dow Jones. But even the changes of interest rates by 0.25% aren't ground-breaking so one could expect that the Dow Jones would "rather often" oscillate away from the target by more than 10%. So it wouldn't be a completely safe investment with a 6% return. But it would be safer than today and I think it should be safer. One of consequences would be that a greater number of people would have savings in stocks because those would be somewhat safer than they are today. Because the promised higher stability would make stocks more attractive, people would probably go to stocks as soon as the new policy is announced, which would lead to a higher Dow Jones, and according to my rules, an increase of the interest rates to make the cash more attractive again. I think there's nothing wrong about this expected evolution.

The Dow Jones index is a collection of selected companies. One would have to impose rules so that its percentage as a part of the economy and/or the total capitalization of everything doesn't change too much with time.